Eastern Mediterranean

University

Ahmad Alian 139038

Aigerim Zholchubekova 138068

Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a stock. Fundamental analysts study everything from the overall economy and industry conditions to the financial condition and management of companies.

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THE VIEWS FROM WALL STREET AND ACADEMIA

Two opposing views have been taken about the efficacy of fundamental analysis. Wall Streeters feel that fundamental analysis is becoming more powerful all the time. The individual investor has scarcely a chance against the professional portfolio manager and a team of fundamental analysts.

Some academicians have gone so far as to suggest that a blindfolded monkey throwing darts at the stock listings can select stocks with as much success as professional portfolio managers. They have argued that fund managers and their analysts can do no better at picking stocks than a rank amateur.

THE VIEWS FROM WALL STREET AND ACADEMIA

ARE SECURITY ANALYSTS FUNDAMENTALLY CLAIRVOYANT?

To predict future directions, analysts generally start by looking at past wanderings. “A provenscore of past performance in earnings growth is a most reliable indicator of future earnings growth.”

Such thinking flunks in the academic world. Calculations of past earnings growth are no help in predicting future growth. If you had known the growth rates of all companies during, say, the 1980–90 period, this would not have helped you at all in predicting what growth they would achieve in the 1990–2000 period.

ARE SECURITY ANALYSTS FUNDAMENTALLY CLAIRVOYANT?

IBM had a steady high grower for decades. For a while it was a glaring exception. But after the mid-1980s, even the mighty IBM failed to continue its dependable growth pattern. Remember also Polaroid, Kodak, Nortel Networks, Xerox, and dozens of other firms that chalked up consistent high growth rates until the roof fell in.

Even during the boom years of the 1990s, only one in eight large companies managed to achieve consistent yearly growth. And not even one continued to enjoy growth into the first years of the new millennium. Analysts can’t predict consistent long-run growth, because it does not exist.

WHY THE CRYSTAL BALL IS CLOUDED

It is always somewhat disturbing to learn that highly trained and well-paid professionals may not be terribly skillful at their calling. Unfortunately, this is hardly unusual. Similar types of findings exist for most groups of professionals.

The point is that we should not take for granted the reliability and accuracy of any judge, no matter how expert. When one considers the low reliability of so many kinds of judgments, it does not seem too surprising that security analysts, with their particularly difficult forecasting job, should be no exception.

WHY THE CRYSTAL BALL IS CLOUDED

1. The Influence of Random Events

Many of the most important changes that affect the basic prospects for corporate earnings are essentially random, that is, unpredictable.U.S. government budgetary, contract, legal, and regulatory decisions can have enormous implications for the fortunes of individual companies. So can the incapacitation of key members of management, the discovery of a major new product, the finding of defects in a prescription drug, a major oil spill, terrorist attacks, the entry of new competitors, price wars, and natural disasters such as floods and hurricanes, among others. The stories of unpredictable events affecting earnings are endless.

2. The Production of Dubious Reported Earnings through “Creative” Accounting Procedures

A major problem that the analyst has in interpreting current and projecting future earnings is the tendency of companies to report so-called pro forma earningsIn pro forma earnings, companies decide to ignore certain costs that are considered unusual; in fact, no rules or guidelines exist

Pro forma earnings are often called “earnings before all the bad stuff,” and give firms license to exclude any expenses they deem to be “special,” “extraordinary,” and “non-recurring.”

3. Errors Made by the Analysts Themselves

To be perfectly blunt, many security analysts are not particularly perceptive or critical, and theyoften make egregious errors.The average analyst is just that—a well-paid and usually highly intelligent personwho has an extraordinarily difficult job and does it in a rather mediocre fashion. Analysts are often misguided, sometimes sloppy, perhaps self-important, and at times susceptible to the same pressuresas other people. In short, they are really very human beings.

4. The Loss of the Best Analysts to the Sales Desk, to Portfolio Management, or to Hedge Funds

During the early 2000s, many analysts were seduced away from research to take highly compensated positions in portfolio management or with hedge funds.One of Wall Street’s best-known analysts, Barton Biggs, left Morgan Stanley to form his own hedge fund. He writes about the attractions of his experiences in Hedge hogging. It’s far more exciting, prestigious, and remunerativeto “run money” in the line position of hedge-fund or portfolio manager than only to advise in the staffposition of security analyst. Small wonder that many of the best-respected security analysts do notremain long in their jobs.

5. The Conflicts of Interest between Research and Investment Banking Departments

One indication of the tight relationship between security analysts and their investment bankingoperations has been the traditional paucity of sell recommendations. There has always been some bias in the ratio of buy to sell recommendations, since analysts do not want to offend the companies they cover. But as investment banking revenues became the major source of profits for the majorbrokerage firms, research analysts were increasingly paid to be bullish rather than accurate.

To be sure, when an analyst says “buy” he may mean “hold,” and when he says “hold” he probably means this as a euphemism for “dump this piece of crap as soon as possible.” Indeed, the analysts’ strong buy recommendations underperformed the market as a whole by 3 percent per month, while their sell recommendations outperformed the markets by 3.8 percent per month.

The situation today is somewhat improved. Outright “sell” recommendations have become more common, although the bias to “buy” advice remains.

In the early 1990s, the Wall Street Journal started a dartboard contest in which each month the selections of four experts were pitted against the selections of fourdarts.By the early 2000s, the expertsappeared to be somewhat ahead of the darts. If, however, the performance of the experts wasmeasured from the day their selections and their attendant publicity was announced in the Journal(rather than from the preceding day), the darts were actually slightly ahead. Does this mean that thewrist is mightier than the brain? Perhaps not, 

Wall Street Journal throwing darts contest

Many funds beating the averages . some by significant amounts. The problem is that no consistency to performance. Why ?1. past earnings growth cannot predict future

earnings2. Fund managements are also subject to random

events

One is tempted to conclude that a very important factor in determining performance ranking is our old friend Lady Luck

the performance rankings of mutual funds show many funds beating the averages?

yesterday’s star fund has proven to be today’s disasterThe following table presents the 1980 to 1990 performance for the twenty top funds of the 1970–80 period. Again, there is no consistency. Many of the top funds of the 1970s ranked close to the bottom during the 1980s

coin flipping contest The contest begins and 1,000 contestants flip coins. Just as would be expected by chance, 500 of them flip heads and these winners are allowed to advance to the second stage of the contest and flip again. As might be expected, 250 flip heads. Operating under the laws of chance, there will be 125 winners in the third round, 63 in the fourth, 32 in the fifth, 16 in the sixth, and 8 in the seventh. This contest depend on chance and explain the laws of chance do operate in mutual funds and that they can explain some amazing success stories. Investors who seem to beat the market year after year are just lucky

Do actively managed mutual funds beat the market?

can be earned by using trading systems based on announcements of new fundamental information(Stock Splits Dividend/Earnings Announcements)? NO

* *the market in adjusting so rapidly to new information that it isimpossible to devise successful trading strategies on the basis of such news announcements(efficiency market)

CAN ANY FUNDAMENTAL SYSTEM PICK WINNERS?

but some research has also been done on the usefulness of dividend increases as a basis for selecting stocks that will give above-average performanceThe argument is that an increase in a stock’s dividend is a signal by management that it anticipates strong future earnings and the result strong price performance

Many professional investors move money from cash to equities or to long-term bonds on the basis oftheir forecasts of fundamental economic conditions.trying to do market timing is likely, not only not to add value to your investmentprogram, but to be counterproductive.”

Mutual fund managers have been incorrect in their allocation of assets into cash in essentially every recentmarket cycle.

THE VERDICT ON MARKET TIMING

the allocation to cash of mutual-fund managers was almost invariably at a low during peak periods in the market. For example, the cash position of mutual funds was near an all-time low in March 2000, just before the market began its sharp decline. The ability of mutual-fund managers to time the market has been egregiously poor.

Over a fifty-four-year period, the market has risen in thirty-six years, been even in three years, and declined in only fifteen. Thus, the odds of being successful when you are in cash rather than stocks are almost three to one against you. An academic study by Professors Richard Woodward and Jess Chua of the University of Calgary shows that holding on to your stocks as long-term investments works better than market timing because your gains from being in stocks during bull markets far outweigh the losses in bear markets. The professors conclude that a market timer would have to make correct decisions 70 percent of the time to outperform a buy-and hold investor.

{The academic community has rendered its judgment. Fundamental analysis is no better than technicalanalysis in enabling investors to capture above-average returns.

THE SEMI-STRONG AND STRONG FORMS OF THE EFFICIENT-MARKET THEORY

“semi-strong” form says that no public information will help theanalyst select undervalued securities? the structure of market prices alreadytakes into account any public information- The “strong” form saysthat absolutely nothing that is known or even knowable about a company will benefit the fundamentalanalyst even “inside” information can't help theinvestors.

FORMS OF THE EFFICIENT-MARKET THEORY

The strong form of the theory is clearly an overstatement. It does not admit the possibility ofgaining from inside information but the information superhighway carries news And Regulation FD (Fair Disclosure) requires companies to make prompt publicannouncements of any material news items that may affect the price of their stock

FORMS OF THE EFFICIENT-MARKET THEORY

The (weak) form of the theory saysthat technical analysis looking at past stock prices cannot help investors because Prices move from periodto period very much like a random walk-The (semi-strong and strong) forms state thatfundamental analysis is not helpful either

FORMS OF THE EFFICIENT-MARKET THEORY

All affecting the company that might be studied by the fundamental analyst, is already reflected in the price of the company’s stock Thus, purchasing a fund holding all the stocks in a broad-based indexwill produce a portfolio that can be expected to do as well as any managed by professional securityanalysts.

- The efficient-market theory does not, as some critics have proclaimed, state that stock pricesmove aimlessly and erratically and are insensitive to changes in fundamental informationOn the contrary, the reason prices move randomly is just the opposite (prices move so quickly when information arises—that no one can buy or sell fast enough to benefit)-It cannot be predicted by studying either pasttechnical or fundamental information.

Benjamin Graham(the father of fundamental security analysis) said in interview : “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago

The view of most investment managers is that professionals certainly outperform all amateurand casual investors in managing money and believes that professionally managed investment portfolios cannot outperform randomly selectedportfolios of stocks with equivalent risk characteristics

THE MIDDLE OF THE ROAD: A PERSONAL VIEWPOINT

Random walkers claim that the stock marketadjusts so quickly to new information that amateurs buying at current prices can do just as well as the ProsThus, the value of professional stock pickers’ advice is nil

THE MIDDLE OF THE ROAD: A PERSONAL VIEWPOINT

• I walk a middle road. I believe that investors might reconsider their faith in professional advisers, but I am not ready to damn the entire field

• He admit that exceptions to the rule of the efficient market exist but worry about accepting all tents of the efficient market theory

THE MIDDLE OF THE ROAD: A PERSONAL VIEWPOINT

the efficient-market theory impliesthat no one possesses monopolistic power over the market and that stock recommendations based onunfounded beliefs do not lead to large buying. But firms specializing in research services and variousinstitutional investors wield considerable power in the market and can direct tremendous moneyflows in and out of stocks. In this environment, it is quite possible that erroneous beliefs about a stockby some professionals can for a considerable time be self-fulfilling

Conclusion